Daniel S. Burks, Tax Matters Partner v. U.S., (CA 5 2/9/2011) 107 AFTR 2d ¶2011-447
In a consolidated appeal, the Court of Appeals for the Fifth Circuit, reversing the district court and affirming the Tax Court, has held that an overstatement of basis isn't an omission of gross income for purposes of the 6-year limitations period of Code Sec. 6501(e)(1)(A). The Court found that the Supreme Court's Colony decision was controlling. Due to that decision and the fact that Code Sec. 6501(e)(1)(A) was unambiguous, the Court also found that it did not have to determine the level of deference due to IRS regs to the contrary.
Observation: Thus, at last count, the Fourth, Fifth, Ninth, and Federal Circuits, along with the Tax Court, hold that an overstatement of basis is not an omission of gross income for purposes of the 6-year limitations period. The Seventh Circuit agrees with IRS (and its regs) that an overstatement of basis is an omission of gross income for purposes of the 6-year limitations period.
Background. Code Sec. 6501(a) generally provides that a valid assessment of income tax liability may not be made more than 3 years after the later of the date the tax return was filed or the due date of the tax return. However, under Code Sec. 6501(e)(1)(A), a 6-year period of limitations applies when a taxpayer “omits from gross income” an amount that's greater than 25% of the amount of gross income stated in the return. Code Sec. 6501(e)(1)(B)(i) (which was an amendment in the '54 Code to the predecessor of Code Sec. 6501(e)) provides that “in the case of a trade or business, the term “gross income” means the total of the amounts received or accrued from the sale of goods or services (if such amounts are required to be shown on the return) prior to the diminution by the cost of such sales or services.” Code Sec. 6501(e)(1)(B)(ii) (which was also an amendment to the predecessor of Code Sec. 6501(e)) provides that in determining the amount omitted from gross income, an amount that is omitted from gross income stated in the return isn't taken into account if it disclosed on the return or in a statement attached to the return, in a manner adequate to apprise IRS of the nature and amount of the item.
The Supreme Court, interpreting the predecessor statute to Code Sec. 6501(e)(1)(A), held that the extended period of limitations applies to situations where specific income receipts have been “left out” in the computation of gross income, and not something put in and overstated. (Colony, Inc. v. Com., (S Ct 1958) 1 AFTR 2d 1894, 357 US 28)
The Fourth Circuit, reversing a district court (Home Concrete & Supply, LLC v. U.S., (CA 4 2/7/2011) 107 AFTR 2d ¶2011-425), the Ninth Circuit, affirming the Tax Court (Bakersfield Energy Partners v. Comm. (CA 9 6/17/2009), 103 AFTR 2d 2009-2712), and the Court of Appeals for the Federal Circuit, reversing the Court of Federal Claims (Salman Ranch Ltd. et al. v. U.S., (CA FC 7/30/2009) 104 AFTR 2d 2009-5640), have held that the Supreme Court's holding in Colony had continuing application under the re-codified Code Sec. 6501(e), and that an overstatement of basis isn't an omission of gross income for purposes of the extended limitations period.
On the other hand, the Court of Appeals for the Seventh Circuit, reversing the Tax Court, has held that an overstatement of basis is an omission of gross income for purposes of the 6-year limitations period of Code Sec. 6501(e)(1)(A) (Beard v. Comm. (CA 7 1/26/2011), 107 AFTR 2d 2011-552). Other courts have agreed (Brandon Ridge Partners v. U.S., (DC FL 7/30/2007) 100 AFTR 2d 2007-5347).
IRS issued final regs in December of 2010 under which an understated amount of gross income resulting from an overstatement of unrecovered cost or other basis is an omission of gross income for purposes of the 6-year period for assessing tax and the minimum period for assessment of tax attributable to partnership items (Reg. §301.6501(e)-1(e)). The final regs adopt the position IRS had held in temporary regs. IRS disagrees with the courts that hold that the Supreme Court's reading of the predecessor to Code Sec. 6501(e) in Colony applies to Code Sec. 6501(e)(1)(A). IRS takes the position that when Congress enacted the '54 Code, it effectively limited what ultimately became the holding in Colony to cases subject to the '39 Code. Moreover, under Code Sec. 6501(e)(1) of the '54 Code (which remains in effect under the '86 Code), when outside of the trade or business context, the definition of “gross income” in Code Sec. 61 applies. So, the regs provide that any overstatement of basis that results in an understatement of gross income under Code Sec. 61(a) is an omission from gross income under Code Sec. 6501(e)(1)(A).
Facts. Daniel Burks, M.I.T.A., and John E. Lynch (collectively, Taxpayers) utilized a Son of BOSS (Bond and Option Sales Strategy) tax shelter to create artificial tax losses in order to offset capital gains. In a Son of BOSS shelter, partners engage in various long and short sale transactions and transfer the resulting obligations to the partnership to improperly inflate the basis in the partnership assets. The partners do not reduce the basis by the liabilities assumed by the partnership. When basis is overstated, gross income is affected to the same degree as when a gross-receipt item of the same amount is completely omitted from a tax return.
IRS issued Final Partnership Administrative Adjustments (FPAAs) adjusting the partnership tax returns filed by Taxpayers on the grounds that the challenged transactions lacked economic substance. The FPAAs were filed more than 3 years, but less than 6 years, after Taxpayers' tax returns were filed with IRS. Taxpayers moved for summary judgment before the district court and Tax Court on the grounds that the government had issued the FPAAs after the expiration of the general 3-year limitations period for assessing tax against the various partners. IRS asserted that the extended 6-year limitations period under Code Sec. 6501(e)(1)(A) applied because the partners had omitted gross income in excess of 25% from their tax returns when they overstated their basis.
In U.S. v. Burks, the district court held that an earlier Fifth Circuit decision in Phinney v. Chambers, (CA 5 1968) 21 AFTR 2d 651, established that an overstatement of basis was an omission from gross income under Code Sec. 6501(e)(1)(A). In Phinney, the Court found that the taxpayer's disclosure wasn't adequate to avoid the 6-year limitations period where the final payment on an installment sale (84% of which was taxable gain) was reported as a sale of stock that had been acquired and then sold at its basis (resulting in no gain). When the district court denied Burks's motion for summary judgment, the Fifth Circuit allowed him to file an interlocutory appeal.
In Comm. v. M.I.T.A., the Tax Court relied on the Supreme Court's decision in Colony to conclude that an overstatement of basis did not constitute an omission from gross income under Code Sec. 6501(e)(1)(A). The Tax Court found that Phinney did not directly address the issue before the court. When the Tax Court granted the taxpayers' motion for summary judgment, IRS appealed.
Fifth Circuit's decision. The Fifth Circuit concluded that the 3-year statute of limitations in Code Sec. 6501(a) applied, and that the FPAA was untimely. The Court found that the Supreme Court's holding in Colony continued to apply to Code Sec. 6501(e)(1)(A) and that Taxpayers' overstated basis in property wasn't an omission from gross income that extends the limitations period under Code Sec. 6501(e)(1)(A).
The Fifth Circuit found that Phinney did not limit Colony's holding. In Phinney, the taxpayer's return did not merely misstate an amount, but rather misrepresented the very nature of the item reported such that IRS could not have reasonably known what was actually being reported—an almost direct omission. The Court concluded that a fair reading of Colony and Phinney supported its finding that both an actual omission of an amount from the tax return, or a fundamental misstatement of the nature of an item reported in a tax return that places IRS at a disadvantage in detecting the error, may result in application of the 6-year extended limitations period. But, an overstatement of basis that adequately appraises IRS of the nature of the item being reported does not constitute an omission from gross income for purposes of Code Sec. 6501(e)(1)(A).
The Fifth Circuit, joining the Fourth, Ninth and Federal Circuits, found that the Supreme Court's Colony holding with respect to the definition of “omits gross income” remained applicable in light of the revisions to the Code. This language, which the Supreme Court construed in the predecessor to Code Sec. 6501(e)(1)(A), was identical to the language at issue in Code Sec. 6501(e)(1)(A). Moreover, the Appeals Court was not convinced that applying Colony would render Code Sec. 6501(e)(1)(B)(i) superfluous—that provision provides an alternative to the customary definition of gross income in the context of sales of goods or services by a trade or business by defining “gross income” as gross receipts rather than gross receipts less the cost of goods sold.
Because the Fifth Circuit held that Code Sec. 6501(e)(1)(A) was unambiguous and its meaning was controlled by the Supreme Court's Colony decision, it found that it didn't need to determine the level of deference owed to IRS's regs. While the regs attempted to define “omits from gross income” for purposes of the revised Code, the Court noted that IRS cited no authority to refute Colony's finding that Code Sec. 6501(e)(1)(A) was unambiguous with respect to the definition of “omits.” The Court found that the regs, as an unreasonable interpretation of settled law, were not applicable to Taxpayers. It accordingly did not determine whether the regs could apply retroactively.
References: For the six-year assessment period, see FTC 2d/FIN ¶T-4201; United States Tax Reporter ¶65,014.15; TaxDesk ¶838,016; TG ¶70538.